Don’t Stress Over Bank Stress Tests

For about two decades I was either a lead market maker or specialist in hundreds of bank stock options. One of the most difficult periods, of course, was during the financial crisis of 2008. Some banks and brokers infamously failed, while a slew of others required taxpayer-funded bailouts. One of the legacies of that era is the requirement that the largest bank holding companies ^[1] submit themselves to stress tests administered by the Federal Reserve. The early stress tests brought the potential for heightened uncertainty. As investors became more accustomed to the process, the results became more about the banks’ ability to return capital to investors via dividends and stock buybacks. The results of the major tests are due this afternoon. 

There are two components to the stress testing process. One is the Comprehensive Capital Analysis and Review (CCAR), the other is the Dodd-Frank Act stress testing (DFAST). The Federal Reserve’s website describes it this way:

The Comprehensive Capital Analysis and Review (CCAR) is an annual exercise by the Federal Reserve to assess whether the largest bank holding companies operating in the United States have sufficient capital to continue operations throughout times of economic and financial stress and that they have robust, forward-looking capital planning processes that account for their unique risks.

As part of this exercise, the Federal Reserve evaluates institutions’ capital adequacy, internal capital adequacy assessment processes, and their individual plans to make capital distributions, such as dividend payments or stock repurchases. Dodd-Frank Act stress testing (DFAST)–a complementary exercise to CCAR–is a forward-looking component conducted by the Federal Reserve and financial companies supervised by the Federal Reserve to help assess whether institutions have sufficient capital to absorb losses and support operations during adverse economic conditions.

While DFAST is complementary to CCAR, both efforts are distinct testing exercises that rely on similar processes, data, supervisory exercises, and requirements. The Federal Reserve coordinates these processes to reduce duplicative requirements and to minimize regulatory burden.

For many years the results of CCAR and DFAST were released in successive weeks. Today the Fed will be releasing both at the same time. Because the tests are similar, and because the banks are believed to be in generally solid shape after over a year of unprecedented monetary stimulus, it makes sense not to prolong the process unnecessarily. Today’s results are expected to be much less about capital adequacy and the potential for capital return than about how much capital the banks will be allowed to return capital to shareholders. Quite simply, today’s stress test results are believed to be about how much good news shareholders will receive. 

Could a bank be blindsided by a negative result? Of course, and that would likely be a big blow to complacent investors. That said, I have found well-respected analysts to be in a broad consensus that such an outcome is highly unlikely. That creates a different set of risks and rewards for bank stock investors. Banks typically announce dividend changes and buybacks shortly after the stress tests – assuming of course that they have been approved to do so. Analysts and investors will be making decisions whether the coming dividends and buybacks meet their expectations, and stocks should react accordingly in tomorrow’s trading. 

Those are crucial decisions, to be sure, but they are nowhere close to the type of uncertainty that reigns during times of economic crisis. As I noted earlier, investors are widely expecting good news – the question is how good, and how it relates to expectations. That could offer some volatility for bank stock investors over the coming days, but it is unlikely to result in major shakeups to the sector. 

---

^[1] According to this Federal Reserve press release, this is the list of affected bank holding companies:

The following 19 firms are required to participate in Dodd-Frank Act Stress Test (DFAST) 2021: Bank of America Corporation; The Bank of New York Mellon Corporation; Barclays US LLC; Capital One Financial Corporation; Citigroup Inc.; Credit Suisse Holdings (USA), Inc.; DB USA Corporation; The Goldman Sachs Group, Inc.; HSBC North America Holdings Inc.; JPMorgan Chase & Co.; Morgan Stanley; Northern Trust Corporation; The PNC Financial Services Group, Inc.; State Street Corporation; TD Group US Holdings LLC; Truist Financial Corporation; UBS Americas Holding LLC; U.S. Bancorp; Wells Fargo & Company. In addition to DB USA Corporation, DWS USA Corporation, a second U.S. intermediate holding company subsidiary of Deutsche Bank AG, is subject to DFAST 2021.